Tariff Anxiety? How to Financially Model the Impact of Tariffs

The following is a guest article byDave O'Brien, Chartered Professional Accountant and Senior Engagement Manager at Sapling Financial Consultants. The views expressed in this article are solely those of the author.

Businesses are broadly concerned about the impact of tariffs on their operations. In conversations with business leaders, many have mentioned the challenges posed by uncertainty. Without knowing the scope of tariffs, the goods involved, or the rates, companies find it difficult to assess the full impact. In such times, financial model stress testing becomes a key tool, helping financial leaders understand how to navigate market uncertainty.

Stress Testing: Definition and Its Significance for Markets and Businesses

Financial model stress testing involves adjusting and rerunning a financial model to assess the financial impact of various internal or external factors, such as a factory closure or the loss of a major client. In the context of tariffs, impacts could include the loss of international customers or increased costs for imported goods.

Through stress testing, business leaders can run multiple scenarios to assess the impact of different tariff levels on profitability, liquidity, and cash flow. Decision-makers can then respond wisely. The core purpose of stress testing is to incorporate all available information into forecasts, enabling decision-makers to make precise adjustments to the business rather than broad-brush changes, thereby protecting resources and capacity and emerging from trade wars as unscathed as possible.

Another benefit of stress testing is that it helps secure support from key stakeholders such as the board, investors, lenders, or employees for planned changes. Decisions based on sound reasoning are more likely to gain acceptance than those relying on intuition.

Incorporating scenario analysis into a stress test model allows for assessing performance under multiple conditions. It is recommended to build at least three major scenario categories:

1. Baseline scenario:Assumes business operations as if the crisis had not occurred. Ideally, use a model that investors and lenders have already run, which helps understand variances from expected returns and provides a baseline for future recovery.
2. Stress scenario (without mitigation measures):Starting from the baseline scenario, reduce revenue based on revised expectations (e.g., considering the impact of the COVID-19 crisis). This scenario does not include any mitigation measures (such as layoffs or loan arrangements) and is used to estimate the maximum cash shortfall in the worst-case scenario. Multiple versions can be run based on different shutdown durations and revenue declines.
3. Stress scenario (with mitigation measures):Based on the revenue projections from the stress scenario without mitigation, overlay measures such as layoffs and cost reductions to show the expected cash position. Similarly, multiple versions can be run based on different shutdown durations.

Tariffs Looming: Market Impact and Mitigation Strategies

Tariffs can negatively affect business performance by reducing overseas market demand and increasing import costs, impacting industries such as energy, automotive manufacturing, agriculture, and food. Businesses facing tariffs may encounter similar challenges, including:

• Declining sales:Passing tariff costs on to customers may lead to lower sales volumes.
• Pricing structure adjustments:If tariff impacts cannot be fully passed on, pricing adjustments may be needed, and discounts could help boost sales.
• Rising costs:Supply costs may increase, especially for materials sourced from the U.S., which will squeeze profit margins.
• Cash flow challenges:Short-term forecasts need to be monitored to assess the cash position and to seek short-term financing for potential liquidity gaps.

Although businesses face similar challenges, the degree of impact and viable mitigation measures may differ. To preserve cash and profitability, companies can consider various actions, such as:

• Increasing domestic sales efforts
• Renegotiating with suppliers or finding new suppliers
• Extending accounts payable days to preserve cash
• Seeking new forms of financing
• Workforce reductions
• Closing underperforming or redundant factories, warehouses, and offices

A detailed and dynamic stress test model allows users to incorporate the above impacts and responses into revised forecasts to anticipate financial performance under multiple scenarios and adjust the intensity of mitigation measures to ensure the business maintains cash flow.

Data and Analysis Over Intuition

When facing any difficult business decision, it is best to rely on facts and analysis rather than intuition. Economic uncertainty is particularly challenging for businesses because it makes impacts difficult to quantify.

Stress testing is highly valuable to businesses, as it helps assess the impact of various economic shocks, quantify the extent of mitigation measures needed, and analyze the effects of these measures on the business. In summary, a well-constructed stress test model helps leaders gain a deeper understanding of the business and the impact of economic shocks.